Centro decision and implications for board remuneration committees
04/07/2011
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The decision handed down on 27 June 2011 by Middleton J of the Federal Court in the ‘Centro Case’ (ASIC v Healey [2011] FCA 717) demonstrates how demanding a director’s duties in approving financial statements can be.

The Centro decision is a case about financial reporting.  This has implications for the board remuneration committee, given that the financial statements and the laws pertaining to them include the directors’ remuneration report. However, the Centro case highlights that remuneration reports should not just be the concern of the remuneration committee. A director cannot simply represent a particular field of expertise – “a director is not relieved of the duty to pay attention to the company’s affairs which might reasonably be expected to attract inquiry, even outside the area of the director’s expertise”.

ASIC’s opening submission in the Centro Case was that the errors in the financial statements were so obvious that the Court had to conclude that the directors had breached the required standard of due care and diligence – this was referred to in the proceedings as the ‘Blind Freddy’ proposition.  Middleton J accepted that, to a degree, directors may rely on the processes they had put in place, and on management and external advisers, to assist them in fulfilling the requirements imposed on them. However, directors will only have taken all reasonable steps in relation to the financial statements if they take the additional step of reading and understanding the financial statements.  While reliance on others is legitimate, it ceases to be reasonable when a director is aware of circumstances that would cause a prudent person to question what he or she is being told. 

In terms of remuneration reporting, we see this all the time.  How many remuneration reports say that reward is contingent on stretch targets, or that pay varies with performance, when above target bonuses are paid and the share prices do not move, or NPAT is lower than prior?  More than a few!

Directors would need to consider a statement that executives are paid at reasonable market rates given their experience and their duties. What “market”?  How was it measured?  What comparison companies and positions were used to assess this?  This is not to say that directors should rely less on external advisers.  Within the context of the Centro Case, reasonable reliance can be placed on external advisers to assist directors determine the reasonableness of remuneration for the purposes of s211.

The fair value of relative TSR tested share rights plan requiring a Monte Carlo simulation could be said to be very complex and require independent external advice.  But at least one person on the remuneration committee should have enough experience to apply a common sense assessment that the value should be somewhere between 45% and 65% of the share price if no retesting is applied. 

Or in smaller mining, technology and biotech companies where options are granted in lieu of cash, the Black Scholes valuation should be around one third of the share price.

Much was made in the Centro Case of the amount of paperwork the board had to get through.  According to the judgment, information overload is not an excuse for failing to read, understand, and focus on material provided to the board.  If information overload is a problem, directors must increase the amount of time allowed to absorb it, or cause management to decrease the volume of information.

Having acknowledged that remuneration reports are encompassed in the Centro decision, are they material enough to cause concern?  The proxy firms may think so, as do several institutional investors, which apply materiality tests to bonuses, and some cases total remuneration, as a proportion of profits generated.

The case makes interesting reading.  It can be found HERE

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